How The Energy Crash Revealed A Weak Global Economy

Volatility allows for the possibility that prices will recover soon and go to new highs. Any setback is just temporary. The market turbulence, it seems, is merely designed by invisible market gods to test your character as a long-term investor. Don't give in to panic, the investment people say, and you'll be rewarded.

Until you aren't!

A year ago I said the crash in commodity prices signaled a weak economy and that financial markets would eventually have to reflect this fact. The widely watched S&P 500 Index closed at 1,994.99 on January 30, 2015 just prior to the publication of the linked piece. Last Friday's close was 1906.90. The U.S. stock market hasn't exactly reflected the weakness in commodities, but it hasn't gained any ground either.

In addition, last August I wrote that low oil prices were also a reflection of this weakness and that all the talk about cheaper oil giving a boost to the economy was misplaced because of the immediate loss of oil-related employment and of revenues to companies and to governments which, of course, tax the oil. The S&P 500 is down about 200 points since then, but any significant adjustment still looks like it lies in the future. Related: Rumors of OPEC-Russia Coordination Send Oil Prices Surging

Of course, starting in August stock markets around the world began to fall. Central banks reacted with words of support, and the U.S. Federal Reserve Board of Governors put off a long-anticipated interest rate hike because of weak market conditions.

Stock prices then rebounded to near their previous levels and all was forgotten...until the beginning of this year. The continuing rout in oil prices began to underline not only the weakness in the global economy, but also the unclear situation at major banks holding large energy-related loan portfolios. The Dallas Federal Reserve Bank was reported to have encouraged banks in its jurisdiction to forebear on energy loans. Essentially, the Dallas Fed was telling banks to ignore losses in their energy portfolios until further notice so as not to cause a panic. The reserve bank quickly denied any such guidance to member banks.

What many average investors don't seem to know is that rallies in bear markets tend to be steep and dramatic, while rallies in bull markets tend to be more muted, taking place over longer periods. It should also be said that corrections in bull markets are often the kind we saw in August and January, dramatic and steep. But there comes a time in the life of every bull market when the dramatic, steep corrections just keep going and turn into a crash. Just ask those playing the oil market.

Perhaps we are not yet there for stocks. Bull market psychology is very hard to dent, especially after one of the longest positive runs in history. Even though stock prices have become detached from economic realities--crashing commodities being the reality I watch closely--stocks have continued to rally back after steep losses based on investors' buy-the-dip psychology. The last recession began in December 2007, but the crash didn't come until almost a year later.

Investors in oil and other commodities and in commodity-related companies have had their heads handed to them. Stock markets in commodity-exporting countries have also fallen steeply. The central banks can't control commodity prices the way they control money and credit. For that reason, I think commodities are a better overall gauge of strength in the economy. Related: Only Recession Can Prevent An Oil Price Spike

The question for investors this year will be something like this: Can central banks keep stock markets around the world afloat despite poor fundamentals? I'm doubtful. They didn't prevent a crash in 2001 or 2008, the first the result of a tech bubble and the second the result of a housing bubble. Both bubbles were caused by easy credit due to low-interest rate policies by central banks that stoked overinvestment. With short-term interest rates near zero for seven years in major economies, central banks are repeating the same mistake again.

Contrary to popular belief, central banks are not omnipotent. The oil and commodity bubbles they helped to blow have already burst. Most of the world's stocks markets are already in bear territory as of January 20. Before the late-week bounce, the U.S.-based S&P 500 Index was down 14 percent from its high in May last year. The Nasdaq Composite was off 16 percent. It's doubtful that any major stock market will simply continue to ignore what is happening in the real economy for too much longer.

Oversupply in the oil market may explain much of the drop in the oil price from $100 per barrel to $40. Some will say that recent additional weakness was due to the lifting of sanctions against Iran, a move that opens the way for substantially higher oil exports.

But oil traders have known about this for months, and it was already priced into futures markets. In my view, only exceptional weakness in the global economy explains oil dipping into the $20 range. In doing so, the oil market has provided a warning for anyone who is willing to see it.